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What to know about 401(k) plans amid talk of tax change

Congress is looking for ways to raise revenue as part of a tax overhaul plan, and one of the methods reportedly under consideration is to curtail how much pretax money workers can contribute to their 401(k) and

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What to know about 401(k) plans amid talk of tax change

STAN CHOE
Published 4:46 p.m. ET Oct. 23, 2017

FILE - In this Monday, Aug. 24, 2015, file photo, people walk past the New York Stock Exchange. Congress is looking for ways to raise revenue, and one of the methods reportedly under consideration is to limit how much pre-tax money workers can contribute to their 401(k) and similar accounts. If it were to happen, the move would strike at a way that tens of millions of Americans use to save for retirement. (AP Photo/Seth Wenig, File)(Photo: Seth Wenig / AP)

Congress is looking for ways to raise revenue as part of a tax overhaul plan, and one of the methods reportedly under consideration is to curtail how much pretax money workers can contribute to their 401(k) and similar accounts. Such a move would strike at a way that tens of millions of Americans use to save for retirement.

The suggestion has already run into some resistance, even if it isn’t an official policy proposal. President Donald Trump said Monday in a tweet that “There will be NO change to your 401(k). This has always been a great and popular middle class tax break that works, and it stays!”

Here’s a look at how prevalent the 401(k) has become and how it’s used:

HOW MANY PEOPLE ARE ACTIVELY PARTICIPATING IN A 401(K)?

About 55 million Americans, who altogether have more than $5 trillion invested in the plans, according to the Investment Company Institute, a trade group representing mutual funds.

Roughly $19 of every $100 in U.S. retirement assets is in a 401(k) account. A decade ago, $17 of every $100 was in a 401(k). The rest is in pension funds, Individual Retirement Accounts, annuities and other investments.

WHY ARE 401(k)s SO IMPORTANT?

U.S. households are increasingly in charge of saving for their own retirements.

Traditional pensions, which pay out a set amount to retirees, are growing closer to extinction. Plus, the retirement of the baby boomers is straining the Social Security trust fund, which is expected to run dry in 2034.

Enter the 401(k) account, which Congress created in 1978. It allows workers to set aside some of their pay and avoid paying even a cent of taxes on it until making withdrawals in retirement. By that time, savers may be making less in income than in their working years, which would mean they pay lower income-tax rates.

One of the big benefits of a 401(k) is that it can make saving automatic. Deductions get taken out of each paycheck. A growing number of employers are also automatically enrolling their workers into a 401(k) program and even automatically increasing their contribution rate each year, in hopes of setting workers up for better retirements.

HOW ARE 401(K) ACCOUNTS DIFFERENT FROM OTHER RETIREMENT PLANS?

They allow workers to save more each year for retirement, on a tax-deferred basis. This year, for example, workers can set aside up to $18,000 in contributions. Workers aged 50 and over can contribute up to $24,000.

By comparison, the annual limit for tax-deferred contributions in an IRA is $5,500, or $6,500 for people aged 50 and above.

HOW BIG IS THE TYPICAL 401(K)?

The average balance for a 401(K) was $97,700 at the end of June, according to Fidelity, which looked at 15 million participants in 22,200 plans. That’s a record, and the totals have been rising as the stock market continues to climb and workers set aside more of their pay.

Workers contributed an average of $5,850 to their 401(k) in the 12 months through June, up 4 percent from a year earlier. Proposals have reportedly discussed capping the annual pretax amount as low as $2,400.

The average IRA balance is slightly larger, at $100,200, according to Fidelity.

ARE THERE ANY DOWNSIDES TO A 401(K)?

The menu of available investments isn’t always the best. Workers have filed numerous lawsuits in recent years against their employers, alleging that the 401(k) plan offers only funds that charge too-high fees or that have poor track records.

Even if good options are available, many workers feel uncomfortable making investment choices. That’s one reason employers have been steering many workers into target-date retirement funds. These all-in-one mutual funds shift from risky investments toward safer ones as the targeted year of retirement approaches.

ARE 401(K) PLANS JUST FOR THE RICH?

No, but the rich can get the most benefit. Higher-income workers are able to set aside more of their pay in a 401(k) account than lower-income workers for the simple reason that they have more to save.

But an additional benefit is that the dollars that higher-income workers are deducting from their taxable income would have been taxed at a higher rate than contributions made by lower-income workers. In other words, the tax benefit of a $1,000 contribution is worth more for a higher-income worker than one made by a worker who is several tax-bracket rungs below.

WHY WOULD CONGRESS CONSIDER THIS IN THE FIRST PLACE?

Washington is hoping to cut income-tax rates across the board, but the only way to do that without sending the national debt skyrocketing even higher is to raise revenue elsewhere.

By curtailing the amount of 401(k) contributions that are tax deferred, Congress would be able to reap some of those dollars now rather than waiting to tax them when they’re withdrawn decades in the future.